Comparing Target-Risk and Target-Date Solutions

So says Nathan Voris, large market practice leader for
Morningstar Investment Management in Chicago. Similar to the shift from defined
benefit (DB) to defined contribution (DC) plans, many in the retirement
industry have been moving from target-risk to target-date funds (TDFs). This
reflects the trend toward automation as an answer to participant inertia, but
are plan sponsors moving in the right direction?

According to PLANSPONSOR’s 2014 DC Survey, target-date funds
are available in 69.8% of plans—generally growing in popularity from the micro-
to the mega-sized market—while target-risk funds are in pace at just 39.5%—generally
falling in favor from smaller to larger plans. Approximately one in four plans
offers both types of funds. Interestingly, balanced funds have the highest
availability among plans of all sizes, in place at 73.1% of plans overall.

When it comes to participant understanding, Voris says,
“With target-date funds, you need to know what a target-date fund is and be
familiar with what you’re invested in. In contrast, if you look at a series of
risk-based models, there’s a lot more work to do.” (See “A New
Proposal for Monitoring TDFs.”)

Determining participants’ risk tolerance requires many more
variables than just their birth date, and individual preferences are likely to
change over time—without the participant updating his retirement profile. With
risk-based funds, “the assumption is that individual is responsible enough to
know he needs to come back and take the [risk-capacity] questionnaire
periodically throughout his career.”

For most participants, that level of engagement with the
plan is unlikely, and plan sponsors run the risk of having the decisions of a recent
post-grad affect the investments of a pre-retiree. “A 25-year old, who may have
a long time horizon and be willing to take on more risk, may be in an
aggressive portfolio his entire career because he hasn’t come back into the
plan; as his risk appetite and time horizon changes, his portfolio doesn’t
change along with him.”

As engaged plan sponsors contemplate the challenges of getting
the right investment lineup in place, some large and mega plans suggest a
simpler approach will help participants perform better.

“What we see less and less of is a plan offering a series of
target-date funds as well as a series of risk-based models, conservative to
aggressive,” Voris explains. At plans that still have both in place, which
account for roughly 25% of respondents to the 2014 PLANSPONSOR DC Survey, the
risk-based funds are often a legacy from before the qualified default
investment alternative (QDIA) safe harbor was established.

“If a company does decide to add target-date funds to its
retirement plan offering, there is certainly going to be a pull to keep those
existing risk-based options in the plan. You never want to see plan changes be
perceived as a takeaway,” Voris notes. Maintaining a target-risk approach is
often the result of a more cultural or corporate decision than an investment
one, he adds.

Still, “in the large and mega market, having one risk-based
model—maybe a balanced fund—along with a series of target-date funds [remains]
relatively common. You see that structure if a balanced fund has been in the
plan a long time, even if it has adopted a more modern QDIA,” says Voris. Balanced
funds are much more prevalent, he says, and may serve an important purpose in a
core menu.

“There are a few hybrid or matrix models, if you will. You
might have three risk series—conservative, moderate, aggressive—and then
there’s also a time horizon component.” However, Voris adds, “even in those
hybrid structures, the overwhelming majority of participants either utilize the
default, whatever that would be, or, if they are going through the exercise [to
determine their risk preference], they’re nearly all in that moderate glide
path.”

In plans where the hybrid option is not available,
particularly in the larger end of the market, “You’ll still see a balanced
fund, and often it is one of the most-utilized options beyond the QDIA.” All of
this suggests that, when participants make active (or even passive) decisions
about their investments, they prefer a moderate, or balanced, portfolio. This
likely holds true at any age.

The reason for this phenomenon is uncertain. Plan
participants are often their own worst enemy, so it may come as a surprise that
many favor a course of action that would serve them well both during their
career and throughout retirement. But perhaps it all comes down to
participants’ lack of financial literacy—a balanced approach certainly sounds
appealing, whether one is a new investor (who may not understand what
“conservative vs. aggressive” really means) or approaching retirement—facing upwards
of 30 years of living off investments.

According to Brian O’Keefe, director of research and surveys
for PLANSPONSOR, “Overall, there’s some debate in the industry going on about
how much equity exposure retirees should have. Some argue that, since retirees
must live for 20-plus years in retirement, the glide path should have more
equity exposure or increasing equity exposure during retirement. In many ways,
a traditional balanced fund is probably the best solution, versus a more
complicated target-date fund, but that’s for the plan sponsor to decide.”

For fiduciaries, who must be held accountable for the plan’s
investments, a balanced fund is often perceived as the most defensible position
in the target-date/target-risk debate. “[Plan sponsors] have to be aware that
risk-based models carry a higher level of burden for the participants. When
they’re comparing and contrasting the value of target-date funds vs. managed
accounts vs. risk-based models, they really need to be aware and honest with
themselves,” Voris says. He suggests asking this question: Are my participants
equipped to use a risk-based fund correctly? If yes, sponsors must make sure to
provide the education and guidance participants need to get on the right track
to retirement readiness.

For plan advisers, who are often named as fiduciaries and must
be held accountable for the plan’s investments, a balanced fund may be
perceived as the most defensible position in the target-date/target-risk debate
as well. But as a consultant to the plan, Voris says, plan advisers need to
make sure their plan sponsor clients are aware of the added difficulties of
risk-based models. “If they have an opinion that the target-date is superior to
the risk-based, or vice versa, they need to make that opinion known.”